Why the Bull Market Will Continue in 2018

Allen Sinai, PhD, CEO and chief global economist at Decision Economics, Inc., a financial advisory firm based in Boston and New York City. He has been an adviser to several US presidential administrations. DecisionEconomicsInc.com

Published Date: January 1, 2018

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After a supercharged year for stocks in 2017, how much more energy can the aging bull market muster? “Plenty,” says renowned economist and Bottom Line Personal regular contributor Allen Sinai. He expects stocks to continue to set record highs for the next few years. The bull market, already the second-longest and approaching nine years, will be powered in its late stages by a surprisingly vigorous US economy and help from congressional revisions to the federal tax code, he adds. Here’s what ­Sinai sees ahead…

Robust Economic Growth

The economy has been undergoing a healthy change. In the years following the Great Recession of 2007–2009, the US was able to eke out subpar annual economic growth of just 2%, on average, as measured by gross domestic product (GDP). However, that rose to 3.1% in the second quarter of 2017…3% in the third quarter…and 2.5% to 3% in the fourth quarter.

What has changed?

First, consumer spending, which accounts for about 70% of annual GDP, has been showing strength. Overall, US household income is rising nicely as more people are going back to work. The unemployment rate has dropped to levels not seen since 2000. Business spending is picking up in reaction to sales and profit growth. Even more important, most of the world’s major economic powers are experiencing a dramatic turnaround, registering increased economic growth all at the same time. That’s significant because exports make up 45% of total sales for companies in the Standard & Poor’s 500 stock index. My forecast for foreign growth: Japan’s economy is likely to grow 2.5% in 2018, up from 1.5% in 2017…the European Union, 2.5%, up from 1.5%…emerging markets, 3.5%, up from 3%…and even China, which had suffered from a slowdown in recent years, will grow by 7%, up from 6.7%.

Added Stimulus FROM Tax Cuts

For stocks to achieve the two years of strong returns that I expect, the newly invigorated economy will need additional help from Washington, DC. I think we’re likely to receive that in the form of $1.5 trillion worth of corporate and individual tax cuts over the next decade.

As of mid-November, Congress was wrestling with the specifics of a controversial proposed overhaul of the tax code. It was considering a sharp cut in the corporate tax rate, from 35% to 20%. Also under the plan, US companies that have been holding billions of dollars overseas to avoid taxes would be able to repatriate that money by paying a 12% tax rate. Both of these tax code changes would make the US more competitive in the race to attract manufacturers and other multinationals and spark greater business spending…more hiring and higher wages.

Also, I would expect businesses to use their tax savings and unlocked money from abroad to either buy back stock and/or raise dividends, a boon to shareholders, or to invest in expanding their companies.

Proposed changes to personal taxes—which might include a rejiggering of income tax brackets…sharp increases in the standard deduction…eliminating the deduction for state and local income and sales taxes…and repealing the alternative minimum tax (AMT)—would have more mixed results, benefiting some individuals and hurting others. But I think the overall effect would be to raise household incomes, boost consumer spending and help increase corporate earnings growth.

Key Economic Measures

Here’s what I expect for 2018…

GDP will likely gain 2.9% in 2018 and 3.3% in 2019, when the proposed tax overhaul would really begin to have an impact. Also, consumer spending should rise by 2.8% in 2018 and 3% in 2019, compared with an estimated 2.5% in 2017.

Unemployment: The unemployment rate likely will be 3.6% at the end of 2018 and 3.3% at the end of 2019, compared with around 4% in late 2017. As employers compete for and strive to retain workers, wages will rise, providing a boost to consumer spending.

Inflation: As measured by the Consumer Price Index (CPI), including food and energy prices, the inflation rate is likely to remain subdued, rising modestly to 2.2% in 2018, compared with 2% over the past year through October. Historically, inflation has risen much faster when there is rising economic growth and a strong labor market, as we have now. The low inflation we have experienced since the last recession has allowed the Federal Reserve to keep interest rates very low, which has played a crucial role in stretching the length of this economic expansion and bull market. Disruptive technology in our everyday lives is keeping prices contained. For instance, apparel prices are under pressure because e-commerce companies have undercut brick-and-mortar merchants. The developing price war between online and retail grocery markets likely will keep food costs under control. Also, persistently low energy prices have played a key role in subduing inflation.

Outlook for Stocks

Although stocks are fairly valued now, they will receive a boost from accelerating corporate earnings growth of 10% to 11%, compared with 7% to 8% in 2017. The Dow Jones Industrial Average is likely to rise 10% in 2018 and the S&P 500 Index 12%. (This includes dividends for both.) Best areas of the market for 2018…

Foreign developed nations, especially the countries of the European Union and Japan. EU economies are enjoying rebounds that should last several years, and their stocks offer more attractive valuations than US stocks. (See more on Japanese stocks on page nine.)

Blue-chip industrials such as the ones found in the Dow. These global companies will see some of the strongest corporate earnings growth because so much of their business depends on ­foreign economies.

Technology, especially fast-growing companies whose products and services are disrupting and changing the way businesses operate and individuals live.

Stock areas to avoid for the coming year: Consumer staples (essential products such as food, beverage and household items), telecommunications and utilities. These steady, slower-growing sectors of the economy aren’t likely to get much attention from investors. They are likely to have positive returns but trail the broad stock market.

Outlook for Bonds

Investors must continue to navigate carefully through a bond bear market because interest rates are likely to rise for years, depressing the value of existing bonds. Following what was expected to be a 0.25% increase in the benchmark short-term rate by the Federal Reserve in December, expect three more rate hikes of 0.25% each in 2018, bringing the benchmark rate to 2.25% by the end of the year. Also, the yield on the 10-year Treasury note, recently 2.4%, should rise to 2.8%. The only return investors will likely get from their bond portfolios is what they capture from interest payments rather than price appreciation.

Bear Market Starting in 2020

The current bull market in stocks is most likely to die in 2020 and turn into a bear market for a conventional reason—the US economy does so well that it overheats. By 2020, I expect inflation could finally be spiking, forcing the Federal Reserve to raise interest rates much more ­aggressively to subdue inflation. Much higher rates would deter consumer and business borrowing and depress corporate earnings growth.

At that point, stocks would suddenly look very overvalued, with poor near-term prospects, leading to a sustained sell-off and a bear market, ­defined as a downturn of 20% or more from the peak in major stock indexes.

Before 2020, my biggest concerns about what might cause the bull market to stumble would be economic and/or geopolitical missteps that could spook investors. These could include, for example, a military escalation between the US and North Korea or an impasse in negotiations over NAFTA that could lead to a trade war with Mexico and/or Canada.

However, these negative scenarios would be more likely to cause great stock market volatility rather than an earlier bear market.